Description

What's the right multiple for the largest zero-carbon energy producer in the United States? In this writeup I hope to show you that Exelon is a classic Michael Price "Steak and Sizzle" investment which offers downside protection and a free option on ESG-driven upside. EXC is trading at $56/sh and in my base case is worth $68/sh (+21%). In an upside case EXC could be worth $100/sh in value (+79%).

Today, Exelon houses two different business lines: 1) regulated utilities and 2) electric power generation & retailing. On February 1, 2022, Exelon will effect a tax-free spin to separate the two companies into Exelon "RemainCo" (utilities) and Constellation "CEG" (generation & retailing).  The two businesses have different earnings streams which attract different investor bases. Utility investors award high PE multiples to stable, predictable earnings and that is what RemainCo will offer. ESG investors love zero-carbon emissions, and CEG has the makings of an ESG powerhouse.

RemainCo Overview

RemainCo's regulated utility business is the largest transmission and distribution-only utility in the United States with a $48B rate base. Areas of operation include Illinois (29% of rate base), MD (21%), PA (17%), DC (5%), NJ (4%), and DE (3%). The balance of the rate base is FERC Transmission (21%).

RemainCo's regulated utilities are granted franchised monopolies. This protects them from competition, but in exchange RemainCo's earnings power is capped by regulators. As a result, the earnings stream is generally predictable and is awarded high multiples from defensive investors. RemainCo guides to $2.25 of 2022 EPS which is expected to grow ~7% for the next three years. Utility peers whose EPS exhibit low volatility and grow in the mid-single digits include CMS, DTE, WEC, ES, LNT, ED and SO. These peers trade at 22x 2022 operating EPS. Applying a peer multiple of 22x to RemainCo's 2022 guidance results in $50/sh for this business.

Constellation Overview

Hidden inside Exelon is the largest producer of zero-carbon electricity in the United States. CEG produces 65% more zero-carbon electricity than the next largest producer (NextEra) and >600% more than the median power producer. As a result, one of of every nine MWhs of clean electricity produced in the United States is by CEG.

Further, its carbon footprint is unmatched: across its entire fleet, for each MWh produced, CEG generates 98lbs of CO2. This is 78% less than its next closest peer, PSEG, and 91% less than the median investor-owned power producer. (Source: M.J. Bradley & Associates Benchmarking Air Emissions, July 2021 https://www.mjbradley.com/sites/default/files/Presentation_of_Results_2021.pdf)

How do they do it? Nuclear. CEG's combined fleet provides nearly 90% carbon-free electricity to a customer base including utilities, municipalities, cooperatives, commercial & industrial entities, residences, and public sector entities. States such as Illinois have recognized the need for nuclear to meet long-term, state-sponsored zero-carbon emission goals. To illustrate this point, CEG was going to de-commision two nuclear power plants in Illinois in 2021. The state decided that was untenable, and granted CEG incentives which amounts to ~$150m/year. Accordingly, CEG reversed their decision to retire the plants. 

RemainCo's valuation above implies that CEG is trading at $7/sh of value or 3.2x EV/EBITDA. Note, some sell-side estimates have missed the following point. CEG today has $4.6b in total debt. However, immediately before the spin, CEG will receive a cash payment from Exelon of $1.75b. This cash payment will bring the net debt balance at CEG to $1.2bn. Using RemainCo's valuation above, and the correct balance sheet as outlined in the Form 10, I estimate that CEG's implied valuation is $7/sh or 3.2x EV/EBITDA.

Power generators have less predictable earning streams than regulated utilities. Accordingly, power generators such as NRG and Vistra trade at 7.0-8.5x 2022 EV/EBITDA. Applying that multiple to CEG results in $18/sh of value in my base case.

Things get interesting if CEG becomes an ESG darling. Predominately renewable power producers trade on very high EV/EBITDA multiples. For example, Brookfield Renewable Partners trades at 24x 2022 EV/EBITDA, and NextEra Energy, the next largest clean energy producer after CEG, trades at 17x. Taking the midpoint and applying a 20x multiple results in $50/sh in an upside case. 

In conclusion, EXC's undemanding valuation protects you on the downside and offers +21% upside in my base case and effectively a free look at ESG mania which could result in an upside scenario of +79%.

DISCLAIMER: I benefit from this stock's appreciation, and have acquired it at a price below the current one. I do not have a specific exit price in mind at this point, and make no promises that I will notify anyone when I sell. I therefore prescribe two grains of salt and a ton of due diligence.

Catalyst

- Upcoming Spin on February 1, 2022

- ESG investor appetite for zero-carbon nuclear power